Wednesday, June 30, 2010

Ricardian Equivalence, when 19th century economics strikes back

Jon Chait, over at The New Republic, has this nice little find from the always entertaining op-ed section of the Wall Street Journal. Today's entertainer is Allan Meltzer of the AEI. Prof. Meltzer seems to have his doubts on the effectiveness of the stimulus. Unlike some more nuanced criticisms, such as Mark Thoma's Stabalization versus Growth issue, Meltzer kicks it old school, using a favorite of conservative economists:

"Most of the earlier spending was a very short-term response to long-term problems. One piece financed temporary tax cuts. This was a mistake, and ignores the role of expectations in the economy. Economic theory predicts that temporary tax cuts have little effect on spending. Unless tax cuts are expected to last, consumers save the proceeds and pay down debt. Experience with past temporary tax reductions, as in the Carter and first Bush presidencies, confirms this outcome."

This notion that temporary tax cuts don't increase consumption because people will defer current consumption to pay for future taxes, whereas permanent tax cuts are good because people will not defer, but consume now, borrows from an idea Robert Barro, an economics professor at Harvard, calls Ricardian Equivalence. In this view, any tax cuts that are financed by adding to the deficit will cause consumers to save more now to offset increased taxes in the future. This relies on the belief that consumers have perfect information and are completely forward-looking, luckily a Noble Prize winner has already been handed out to someone for dismantling this view, Joseph Stiglitz from his new book Freefall, take it away:

Now the interesting thing about Meltzer's argument is that not only does it assume that consumer's are completely forward-looking, ignoring borrowing constraints people face, as well as, the uncertainty people feel towards the futuer, but it also tacks on the belief that consumer's can distinguish between tax cuts that will "pay" for themselves if they are permanent versus those that are temporary, and will be rescinded. This seems like quite a leap of faith to me, surveys show that barely 50% of Americans can accurately name a basic economic idea, the unemployment rate. Until surveys show a massive majority of people understand even these basic ideas, I will be highly skeptical of any claims that consumers can accurately predict the intricacies of economic policy.